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Budgeting 101: What it is and how to build one

At a glance:

One of the most important aspects of investing is cash-flow management, also known as budgeting.

Not only is it necessary for successful investing, it is necessary for attaining most of the things you want in life.

A budget helps you focus on the important things in your life and how to pay for them. A good budget will help you economize and save for these things. It will also help you improve your risk tolerance.

What is a budget?

Everyone who handles money has a budget, whether they know it or not.

It may not be written down, but it is there just the same. For example, mom gives her eight-year-old son a $10 allowance for the week.

Does Sonny go out and spend it on a CD, candy, or school supplies, or does he save it to make a larger purchase in the future? It doesn't matter how you answer the question. However Sonny "spends" the $10, he has made his decision based on his budget, although it wasn't written down.

A budget has two main components: cash coming in (inflows) and cash going out (outflows).

If you subtract the outflows from the inflows, the answer should always be zero. That's called balancing the budget.

So why is budgeting subject to so much angst?

Most persons don't see the difference between income and inflows.

Income is an inflow, but so is money taken from savings and money borrowed. Income is money earned from work, earned from investments, or received as a gift.

Some people try to spend more income than they have, ultimately causing problems in the future, when the budget must be balanced with inflows from either savings or borrowing. Here is a simple example:

Here's an example of a budget balanced with inflows. (Photo: Financial Fitness Group)
Here's an example of a budget balanced with inflows. (Photo: Financial Fitness Group)

The negative $3 cash flow tells us that to balance this budget, Sonny needs an additional inflow of $3. If Sonny had previously saved some money, then he could easily take the $3 from savings and his budget would look like this:

A different version of Sonny's budget. (Photo: Financial Fitness Group)
A different version of Sonny's budget. (Photo: Financial Fitness Group)

If Sonny didn't have any savings, one of two things would happen: He would either have to postpone one of his purchases or he would have to borrow the cash from his mother or another lender.

Budgets are also called "cash-flow management"

A budget is merely a way to identify cash coming in and how we spend it.

It can be a valuable tool for planning future spending and for making investment and borrowing decisions. When used to make decisions about future spending, saving, and investments, it is called cash-flow management.

Budget basics: inflows and outflows

A successful cash-flow management plan starts with a written budget.

In the budget, one defines sources of cash inflows and expenses (cash outflows).

The inflows and outflows must balance. There are three sources of inflows: income, savings, and borrowing.

There are many outflow items, but they are usually described as expenses and grouped together in a few common categories in order to simplify the written plan.

Some expense items may be used as income tax deductions and are customarily grouped to make it easier to identify for income tax return calculations.

Your expenses are either fixed or variable

Expenses may be fixed or variable.

Fixed expenses recur each period (month) and include items such as mortgage or rent payments, automobile payments, utility bills, etc.

Variable expenses generally do not recur each period or their amounts are very different from month to month. Variable expenses include entertainment and vacation costs, and purchases of clothing and household items, etc.

Expenses are either discretionary or non-discretionary

Expenses may also be discretionary or non-discretionary, depending on whether one has a choice of incurring the expense or an option of when to incur the expense.

For example, paying the utility bill is non-discretionary, since if one doesn't pay it, the utility company can turn off service.

Purchasing a replacement automobile is discretionary (left up to your own judgment), since one can choose to buy a new or used car, a luxury or economy car, or can choose the timing of the purchase — now or in the future.

What a budget looks like

The basic budget format and principles

Budgets for a household and for a business may look different, but they use the same basic principles. Some people like to group fixed expenses together and variable expenses with each other.

Others like to categorize all discretionary expenses together and all non-discretionary expenses with each other, too. The method you use is a matter of personal taste and convenience to suit your particular purpose and reporting needs.

The basic layout has all inflows grouped together at the top. Outflows are grouped by expenses and are listed below the inflows. Here is an example:

Here's what a budget looks like. (Photo: Financial Fitness Group)
Here's what a budget looks like. (Photo: Financial Fitness Group)

When making your first budget, you would initially make a guess for each of the inflow and outflow items.

A better method is to review past inflows and expenses over a reasonable period of time (several months or years) and use the average as an educated guess.

Recording inflows and outflows in this way helps to project future cash-flow needs. It also suggests which expenses need to be watched closely in order to economize and avoid waste.

Pay yourself first!

Most financial advisors agree that the best way to avoid financial problems and to save for future expenses is to "pay yourself first."

This means that a certain amount of money from your gross income should be withheld and set aside into a savings plan. In your written budget, this will appear as a negative entry in savings, since the cash flow is going into savings.

By keeping a written record of your income and expenses, you are better able to project when you will need additional inflows from savings or borrowing, and which expenses can be reduced or postponed to a future period when you have better inflows.

The key to a successful budget

The key to a successful financial plan is managing one's cash flow.

Did you ever meet someone who complained, "There is too much month left at the end of the money"?

This can happen more often than one thinks. In fact, it is quite a normal occurrence, even for those in good financial shape.

Why it's easy to fall into debt

Here is why. Most persons have a steady stream of income each month, but their expenses may vary so much that some months have more expenses than inflows from income.

This is usually not a problem, because on those months when the income exceeds expenses, the excess income goes into savings (a negative inflow) that can be used later when expenses exceed monthly income.

It only becomes a problem when monthly expenses exceed monthly income so often that there are not sufficient savings to provide for the difference. When that happens, one is forced to borrow money to balance the inflows and outflows. This leads to increased expenses, because the cost of borrowing money itself (interest) increases monthly expenses.

To stay out of debt, you must economize

To avoid this, one must economize.

Economizing is merely determining how much one can spend on each expense item so that the expenses do not exceed income over time.

Since "income" is the limiting component, one economizes by incurring expenses based upon the amount of income one expects to receive over time. If you had an expectation of $50,000 of income over the next 12 months, you couldn't very well plan to spend $75,000. That just doesn't make sense.

On the other hand, if you had an expectation of $50,000 of income per year for the next three years, and you wanted to spend $75,000 this year and only $37,500 per year (including interest on the borrowed $25,000) for the following two years, that would make sense, because the inflows from income would balance the outflows.

If, instead, you spent only $37,500 per year for two years, you could spend $75,000 in the third year without incurring any interest charges — in fact, you would probably have earned interest on the unspent income for the first two years.

Plan your expenses to match your inflows from income

Economizing means planning your expenses to match your inflows from income over time.

The key to successful economizing is in setting goals and putting them in order. One can usually predict future income fairly accurately. It's the expenses that pose a problem. Some expenses are just not discretionary. But judge carefully.

True, one must have a place to live, but how much one spends depends upon one's goals and priorities. One must buy clothing, but how much one spends depends upon one's goals and priorities. You can make a successful cash-flow management plan by projecting your expenses based upon your short-term, intermediate-term, and long-term income expectations, as well as on your goals and priorities.

Budgeting rules of thumb

When trying to set a budget and economize, one is limited by one's future earnings.

If expenses continually exceed earnings, one has to borrow money to pay expenses.

Eventually, one reaches a point when it becomes impossible to eliminate debt, which may lead to bankruptcy. A few rules of thumb can be used as guidelines in cash-flow management to help formulate your goals and priorities.

Taxes

Many people would like to avoid taxes. However, evading taxes is illegal. Doing so can ruin your budget and really mess up your goals when you are caught.

So let's plan to pay taxes, yet strive to pay the least amount allowable by law.

This means taking advantage of all the legal opportunities available to reduce taxes, such as participation in employer-sponsored retirement and benefits plans, as well as funding your own individual retirement accounts (IRAs).

Federal and state income taxes, Social Security, and Medicare taxes generally will reduce your gross earnings from work by 25–35%. Since these taxes are deducted before you get a paycheck, plan your budget on the net amount. That is, if you earn $50,000 per year, don't plan to spend more than about $32,000.

Inflation

The prices of goods and services tend to increase over time. This is called inflation.

While it is quite impossible to predict future inflation rates, historically they have ranged between 0% and 10% per year in the United States. Under current US fiscal policy, the Federal Reserve is trying to manage inflation between 2% and 4% per year.

To predict the future costs of goods and services due to inflation, the rule of 72 might be helpful.

Rule of 72

The rule of 72 can tell us how long it will take for the price of something to double, if we know the rate of inflation.

Dividing 72 by the inflation rate equals the number of years it will take for the cost to double. You must use a whole number as the rate, rather than a decimal or percentage. That means that if inflation is 3%, use 3, not 0.03.

For example, if you want to know how long it will take for the price of bread to double at 3% inflation, you will proceed as follows: 72/3 = 24 years.

Those of you who passed algebra also see that this formula is useful in determining what rate of return is required, in order for an investment to double in a fixed number of years. Using a hypothetical example, in order for an investment to double in 12 years, the investment return must be 6% (72/12 years = 6% return).

And the rest of you thought algebra was a waste of time!

You can see that using the rule of 72 allows you to predict future costs, income, and savings without using a fancy financial calculator or computer. But remember, it is only a rough estimate.

This illustration does not reflect any actual investment, and investment values will fluctuate. It demonstrates mathematical principles only and should not be regarded as absolute. Furthermore, the periodic declines in markets will diminish the rule's effective application.

How to evaluate your expenses

The most effective method for evaluating your expenses is to take a snapshot of your own spending activity. No two situations are alike.

Here is an example of the expenses you would likely need to take into consideration. These ranges are illustrative in nature and meant to provide broad guidelines based upon gross family income before taxes.

The most effective method for evaluating your expenses is to take a snapshot of your own spending activity. (Photo: Financial Fitness Group)
The most effective method for evaluating your expenses is to take a snapshot of your own spending activity. (Photo: Financial Fitness Group)

In setting your own goals and priorities, if any of your planned (or actual) expenses exceed these guidelines, then perhaps that is an area you need to reconsider.

Summary of budgeting

Everyone has a budget — it's just not always a written one.

When you write down a budget, you have moved up to cash-flow management. This allows you to get a better grasp of your finances and helps you identify areas in which you can economize.

If you use the principle of "pay yourself first," you will avoid the debt trap that can ruin a budget with excess interest. A sound budget is key to successful investing.

Practical ideas you can start with today

  • Calculate your net worth.

  • Pay yourself first by withholding a chosen amount from each paycheck and putting it into savings. Start with an emergency fund.

  • List your fixed and variable expenses and your discretionary and non-discretionary expenses.

  • Make a budget that balances your cash inflows and expenses.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Budgeting section

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